Capital Market's Reaction to Corporate Tax Cut: Theory and Empirical Evidence

First, we investigate the capital market's reaction to a corporate tax cut through the use of financial modeling. By incorporating the change in corporate tax into the Capital Asset Pricing Model (CAPM), we find that apart from expected effects the cost of equity capital increases. This effect has not yet been covered in the literature. Overall the model predicts increased market capitalizations in the wake of a corporate tax cut. Second, we investigate this theoretical prediction empirically. In Austria the corporate tax was cut from
34% to 25% in 2005. The cut's announcement was a surprise for investors; therefore, in this paper we shall analyze the reaction of the Vienna capital market by employing an event study. We find that the theoretical predictions hold in practice. We contribute to previous research by incorporating the effect of a corporate tax cut into the CAPM and by testing this effect empirically.